Risky Business: The Credit Crisis and Failure (Part I)

The credit crisis
represents a watershed event for global financial markets and has been linked
to significant declines in real economy performance on a level of magnitude not
experienced since World War II.[1]Recognition of the crisis in 2008 has been
followed in 2009 and 2010 by a plethora of competing proposals in response to
the credit crisis.[2]The result has been a cacophony of visions, voices, and approaches. The sheer noise that has ensued threatens to
drown out the fundamental core questions that should be asked about the credit
crisis.Among the most important are
questions about the relationships between risk, regulation, and failure.

The credit crisis can
be viewed as a type of financial market network failure.[3]The credit crisis underscores the complex and linked nature of contemporary
financial markets, as well as the inherent difficulties regulators and industry
participants face in managing complex and interconnected risks. The credit crisis also demonstrates that
neither industry participants nor regulators fully apprehended underlying
financial market risks.In recent years,
financial products and financial markets have become increasingly complex and
global.[4]Although public commentary and policy discussions in the credit crisis
aftermath focused on the implications of financial services firms that are "too
big to fail,"[5]
existing commentary devotes less attention to the network-like characteristics
of financial markets and the implications of complex networks for financial
markets.[6]The impact of financial market networks is
heightened by the pervasive cultures of trading and risk-taking that now
characterize many market segments.[7]The risk-taking associated with financial
market trading activities is perhaps best illustrated by cases of individual
traders who took on risky trading positions that significantly compromised or,
in the case of Baring Brothers, destroyed the firms on whose account they
trade.[8]

Over-the-counter (OTC)
derivatives illustrate both financial innovation and the links that connect
financial market participants, such as traders.Derivatives have been a key aspect of financial innovation;[9]
they have "enabled a far greater degree of linkage across markets than at any
other time."[10]

Private legal rules,
often specified in form documents, are typically incorporated into OTC
derivatives contracts.[11]OTC derivatives are traded through private contracts between parties
based on form agreements that permit customization for particular transactional
terms.In contrast, exchange-traded
derivatives, such as futures and options on futures, are traded and cleared
through standardized contracts and bought and sold in organized derivatives exchanges.[12]OTC derivatives markets exemplify the complexity
and trading in financial markets.[13]OTC derivatives are now key building blocks in global financial markets,
with a gross market value of $25 trillion and notional value of $605 trillion
in June 2009.[14]

Not surprisingly, the
character and complexity of financial markets were major factors in the
industry and regulatory failures that preceded the credit crisis.In the aftermath of the credit crisis,
however, failure is often discussed in connection with the financial services
companies that many blame for the crisis.Although blame can and certainly should fall on professional financial
market participants, other failures, including those by regulators, have also
played a significant role in the credit crisis.Further, U.S.
financial market regulation frameworks have not kept pace with financial
innovation.As a result, regulators
often are unable to provide adequate risk oversight for the complex trading and
other activities that increasingly characterize financial markets.

Rhetorically bashing
financial institutions has become commonplace among the media, public officials,
regulatory agencies and the general public.[15]A focus on blaming financial institutions,
however, deflects attention from other failures that contributed to the credit
crisis.[16]Further, few discussions focus to a
sufficient extent on dealing with the industry and regulatory failures that led
to the credit crisis.The credit crisis
aftermath could be seen as actually rewarding those most responsible for the
failure to manage or regulate risky financial market business activities.Through programs such as the Troubled Asset
Relief Program (TARP)[17] and the Public-Private Investment
Program (PPIP),[18] which are government initiatives to
address problems resulting from the presence of "illiquid and troubled assets
on financial institutions' balance sheets,"[19]
industry participants received government bailouts that permitted them to avoid
assuming the full risk of their activities.[20]The bailouts have thus rewarded risk
management failures by averting firm failure, which presents the same
significant moral hazard implications that spawned the current financial crisis
in the first place.[21]

Bailouts reflect
recognition of the networked nature of financial markets today and the
potential systemic impact of firm failures.[22]Because failure is an important market
mechanism, however, preventing failed firms from actually failing serves to
obscure the fact that failure may be both necessary and desirable.[23]Further, although deregulation played a role
in the credit crisis, lax regulation and regulatory failure also contributed to
the credit crisis.[24]As is the case with failed industry
participants, regulators may also be rewarded for their failures by being given
greater regulatory responsibility.[25]Financial market reform proposals would benefit from taking better
account of the implications of the widespread failures of varied market
participants and regulators and focusing to a greater extent on regulatory
effectiveness as both a goal and a metric by which to measure regulatory
success.

This Essay analyzes the
institutional and legal implications of cultures of trading.It discusses the implications of cultures of
trading and considers regulatory reforms that such cultures of trading make
necessary.This Essay also recommends
adoption of regulatory approaches that focus on prevention of future failures
rather than approaches geared toward preventing past failures.An approach that intends to avert future
failures should include a number of elements designed to ameliorate risk.A key element in such an approach would
entail development of mechanisms that force market participants to bear the
risks of their activities.Potential
approaches could involve varied means, such as insurance, industry bailout
pools, and improved industry risk management.These internal industry regulatory initiatives should be part of an
overall regulatory approach that focuses on developing financial market
firewalls to contain the impact of participant failures.Averting future major financial market
failures will also require fundamentally rethinking U.S. regulatory approaches and
implementing regulatory principles that guide regulatory enactment and
reform.These regulatory principles
should focus on creating financial market regulatory frameworks that are
efficient, effective, flexible, transparent and neutral.Ensuring better education of market
participants, regulators, and most importantly investors, should also be a core
goal of financial market regulation.Finally, the global and complex nature of financial markets requires
regulation based to the greatest extent possible on actual market dynamics,
which entails better collection and analysis of relevant data that can then be
used by participants and regulators to avoid future financial market meltdowns.

In the second half of
2008, credit markets became increasingly illiquid, with the U.S. emerging as the epicenter of a global
financial contagion that was precipitated by the unraveling of U.S. housing
markets.[26]Financial institutions throughout the world had exposure to U.S. housing
markets,[27] in part through credit derivatives
such as collateralized debt obligations (CDOs).[28]Other market participants, including monoline
bond insurers and insurance companies such as American International Group,
Inc. (AIG), retained significant exposure to CDOs by virtue of another type of
credit derivative, credit default swaps (CDSs).[29]Companies used CDSs to insure payment
streams for CDOs and other financial instruments.[30]Securitization has contributed to trends in general financial markets
towards cultures of trading by enabling transformation of assets that were
previously not traded and remained on individual companies' balance sheets into
financial instruments with, in many cases, liquid trading markets.[31]

By creating liquid
secondary trading markets for assets such as home mortgages that in the past
remained on individual financial institution balance sheets, credit derivatives
have enabled the spread of credit risk to a broad range of investors throughout
the world.[32]Investors purchasing credit derivatives,
including a wide range of global financial institutions, relied to a
significant extent on existing relationships with financial institutions that
structure, market, and sell such derivatives.These investors also relied on privately generated ratings issued by gatekeepers
such as credit rating agencies, which play a crucial
verification and certification function in fixed income markets.Many structured finance instruments were
actually far riskier than their ratings might have suggested.As a result, flaws in credit rating agency
assessments of structured finance instruments often are considered a principal
underlying cause of the credit crisis.

As the credit crisis
unfolded, uncertainty about the valuation of credit derivatives and other
assets on financial institutions' balance sheets contributed to a liquidity
crunch that exacerbated the impact of the crisis.[33]This liquidity crunch significantly
constrained secondary markets for structured finance securities in ways that
many market participants and regulators failed to anticipate.

The credit crisis
highlights pervasive failures in industry and regulatory risk management.Information and communications technologies,
finance theory, and financial engineering facilitated development of
derivatives markets[34]
and played a role in the risk management of complex financial instruments.[35]However, rather than spreading risk
prior to the credit crisis, financial market innovations tended to hide risk by
complicating it.[36]The seeming ability to quantify and price
risk underscores a conceptual shift in attitudes about risk, which may have
contributed to the credit crisis.[37]The rise of so-called "quants" on Wall Street
led to the era of complex financial products, complex trading strategies and
automated trading, and intricate financial market networks that characterized
financial markets at the time of the credit crisis.[38]

The activities of
quants are exemplified by the rise and fall of Long-Term Capital Management
(LTCM), a hedge fund that nearly failed in 1998.[39]LTCM opened for business in February 1994 after raising $1.25 billion
from a broad range of investors.[40]LTCM, whose principals included prominent traders and two Nobel Prize
winners,[41] employed a dozen or so trading
strategies, some of which involved convergence trades and dynamic hedging.[42]LTCM's trades involved complex strategies and
trades that numbered in the thousands.[43]At one point, LTCM was reported to have over
60,000 trades on its books.[44]LTCM's reputation enabled it to get credit on
easy terms and facilitated its development of connections with other traders
and financial institutions, many of whom were eager to make trades with LTCM.[45]

LTCM's Treasury
arbitrage trade was one of its simpler trading strategies.[46]This trade, in one instance, took advantage
of market discounting of thirty-year U.S. Treasury bonds, which created an
unexpectedly wide spread in yields.[47]In 1994, betting that this spread would
narrow, LTCM bought $1 billion in bonds that its models suggested were
undervalued by the market (the cheaper Treasury bonds), and sold short $1
billion in bonds that its models suggested were overvalued by the market (the
more expensive Treasury bonds).[48]To pay for the cheaper bonds, LTCM borrowed money from several Wall
Street banks and borrowed the more expensive bonds that it sold short.[49]LTCM also loaned the bonds that it bought to
other Wall Street firms, who wired cash to LTCM as collateral for the loaned
bonds.[50]This series of transactions enabled LTCM to
make the $2 billion Treasury arbitrage trades without using any of its own
cash.Maintaining the trade would cost
LTCM a few basis points per month if rates moved as contemplated by LTCM, but could
potentially cost far more if rates moved in an unanticipated manner.[51]

The Federal Reserve
Bank of New York
orchestrated the rescue of LTCM by a private bailout and recapitalization in
the aftermath of bond market volatility surrounding the 1998 Russian debt
default, due to fears about the potential market impact of an LTCM collapse.[52]A clear harbinger of the later credit crisis,
LTCM had leverage of greater than 100-to-1 just prior to its almost $4 billion
bailout.[53]Internal risk management models at LTCM were
insufficient in the face of adverse market conditions in 1998.With more capital, however, LTCM might have
withstood the adverse market conditions.

As was the case with
LTCM in 1998, internal risk management at many financial market firms was not
well-positioned to cope with the market volatility that came with the credit
crisis.[54]The ability of many firms to successfully
endure such volatility has been hindered by a number of factors, including
inadequate risk management, high leverage, and compensation structures that may
have encouraged speculation and incentivized risky trading.Further, misuses of mathematical models also
contributed to the credit crisis.[55]The Gaussian copula function, which was developed by David X. Li,[56]
a Wall Street math wizard, was widely used by various financial market
participants, gatekeepers, and regulators to model complex financial market
risks.[57]Li, who has an M.A. in the actuarial sciences
and a Ph.D. in statistics, reflects a typical trajectory in the "quant" era,
during which Wall Street firms hired Ph.D.s in math and physics to create,
price, and arbitrage increasingly complex securities.[58]The Li formula addresses the problem of
modeling default correlation, which is an important factor in pricing complex
securities and assessing risk.[59]The importance of modeling default
correlation is obvious, for example, in the case of LTCM's treatment of sovereign
bonds.An investor who is investing in
Russian and Mexican bonds needs to understand the extent to which a Russian
default might be correlated with a Mexican default.[60]LTCM failed in part because its models, which were based on 100 years of
historical data, assumed no correlation between a Russian and Mexican default.[61]Contrary to LTCM's models, in 1998 a Russian
and Mexican default were correlated, and because both markets included many of
the same investors, the Russian default led many investors to sell their
Mexican bonds as they attempted to lower the risk levels in their portfolios.[62]The Russian devaluation and default on
certain borrowings ultimately contributed to the collapse of LTCM.[63]

Li's Gaussian copula
model was innovative in that it allowed modeling of CDO default correlation
without the need for historical CDO data.[64]Instead, Li's model used historic CDS spreads
to model default correlation.[65]A CDS price increase thus would be reflected
as an increase in default risk in Li's formula.[66]Li's formula and variants based on it were
widely adopted by industry participants and credit rating agencies, were used
to price billions of dollars of CDOs, and contributed to increases in CDO and
CDS activity.[67]Reliance upon and widespread use of Li's
formula contributed to the credit crisis in part because those making asset
allocation decisions on Wall Street were not quants and did not really
understand the formula's limitations and weaknesses.[68]Further, mathematical models that could
render some measurable (even if incorrect) output also may have lent "credibility
and false precision to the dismal reality of risk management."[69]

Use of derivatives may
also have changed the ways investment professionals frame risk.Wall Street firms that created CDOs and other
complex derivatives may have lessened due diligence and risk assessment of
their creations because they assumed that a liquid market would exist.[70]Risk assessments were shaped by incomplete market
assumptions.[71]Therefore, significant gaps existed in widely
used industry risk management models,[72]
particularly with respect to liquidity risk, which was underpriced.[73]Gaps in risk models and risk management reflected an incomplete
understanding of financial networks and the full implications of trading credit
derivatives and other complex structured products.[74]

The speed of credit
crisis contagion also took many by surprise.[75]Further, the credit crisis unfolded along
with changes to accounting rules for derivatives that require fair value (i.e.,
mark-to-market) reporting in company financial statements, which likely
increased financial statement volatility.[76]Financial statement volatility may result
from fair value accounting because assets and liabilities may need to be
reported based on some measure of market value rather than historical cost
measures.[77]

Derivatives are an
important part of hedging activities and proprietary and client trading
operations for a wide variety of market actors, particularly investment and
commercial banks and hedge funds.On
Wall Street, for example, "trading firms routinely borrow as much as 50 times
the cash in their accounts to trade complex financial instruments such as derivatives."[78]The extensive leverage used in derivatives trading, however, may magnify
risk.[79]In the credit crisis, leverage was an
important factor in financial institution instability because many financial institutions
were engaged in high-risk trading activities, did not have sufficient capital
to withstand a market decline, and found it difficult to raise additional
capital due to liquidity constraints in a frozen credit market.[80]

The Counterparty Risk
Management Policy Group III (CRMPG) is a group of industry participants tasked
with providing a private sector response to the credit crisis.[81]The CRMPG has identified four forces that often
are common denominators in financial contagion: credit concentrations, maturity
mismatches, excessive leverage on balance sheets or embedded in individual
classes of financial instruments, and the illusion of market liquidity.[82]These factors all played a role in the credit
crisis and contributed to its spread through the same networks that connected
market participants during more favorable market conditions.The credit crisis thus illuminates important
perils of networked financial markets and some downside risks of financial
innovation.[83]

Because many financial
market firms were heavily leveraged with insufficient capital, the consequences
of failed risk management did not remain internalized within these firms.Rather, the costs of failed risk management
have been externalized and borne by the general public.As many commentators have noted, this
suggests the need for additional regulation to internalize these externalities,[84]
in part by imposing serious consequences for failure.

The Goldman Sachs "Abacus"
transactions illustrate how trading activities may exacerbate systemic risk.On April 16, 2010, the SEC brought fraud
charges against Goldman Sachs in connection with Abacus 2007-AC1 synthetic CDOs
that Goldman marketed and structured.[85]In contrast to cash CDOs, which contain portfolios of assets, synthetic
CDOs reference an underlying portfolio of CDSs that may
relate to the same types of assets that might be included in a cash CDO.[86]Synthetic CDOs are far faster and easier to assemble than cash CDOs, and
have contributed to growth in credit derivatives markets.Abacus 2007-AC1 was a $2 billion notional
value synthetic CDO that referenced a portfolio of Residential Mortgage Backed
Securities (RMBS).[87]Investors in the Abacus synthetic CDO
included ABN Amro, which was later acquired by a group of banks that included
the Royal Bank of Scotland (RBS).[88]RBS ultimately paid Goldman more than $840
million to terminate ABN Amro's Abacus position and is now government-controlled.[89]Similarly, German bank IKB Deutsche Industriebank
AG purchased $150 million of Abacus synthetic CDOs in April 2007 and lost most
of its investment within months of its purchase.[90]It nearly failed in 2007 before a rescue from
its main shareholder, state-owned KfW Bankengruppe.[91]Synthetic CDOs magnified risk because they
enabled market participants to place bets on the residential housing market
that were far larger than the original market itself.By the end of 2006, although only $1.2
billion in subprime mortgages were outstanding, more than $5 trillion in
investments had been created based on risky subprime loans.[92]AIG, which received over $120 billion in
bailouts from the U.S.
government, insured $6 billion in Goldman-arranged Abacus deals.[93]A number of Abacus investors, including AIG,
IKB, and RBS, were recipients of government bailouts.[94]The systemic impact of these types of trading
activities and the potential for negative societal externalities are
significant concerns in the aftermath of the credit crisis.

Regulation and
internal risk management should share the goal of containing negative
externalities that may flow from trading and other financial market
activities.In addition to regulatory
changes, credit crisis policy responses should strongly encourage financial
market participants to manage risk collectively through mechanisms such as
insurance and industry bailout pools that may help to spread risks of financial
market activities among market participants.Models from other arenas could provide a starting point for shaping
financial market participants' efforts to develop mechanisms to prevent the
externalization of their losses to broader society.Such models could be developed in conjunction
with regulatory mechanisms intended to manage risk.Although implementing industry-sponsored
models is likely to be complex and challenging, the potential avenue for
ameliorating the impact of future market crises that such models offer makes
those efforts worthwhile.In addition to
potentially mitigating systemic risk, or risks to the financial system as a
whole,[95]
these models could also force private market discipline by creating regulatory
frameworks that permit even large or highly-networked market players to
fail.This likely will provide better
incentives for more comprehensive internal industry risk management.

Additional forms of market
insurance might supplement existing financial market insurance programs
available through the Federal Deposit Insurance Corporation (FDIC), which
insures bank deposits, and the Securities Investor Protection Corporation
(SIPC), which insures broker-dealer accounts.[96]In financial markets more generally, varied
insurance mechanisms could be used to ameliorate risk in capital market
contexts.Just as the availability of
insurance for investors reflects regulatory concern for retail market
participants, industry insurance schemes would reflect acknowledgment that even
sophisticated market participants may need to insure against risks of the sort
that led to the credit crisis.Large law
firms in the United States
offer a potential model for self-insurance, even though it is not likely to be
completely transferable to the capital market context.The Attorneys' Liability Assurance Society
(ALAS) was founded in 1979.[97]ALAS membership includes 236 firms and 60,000
lawyers in forty-five states and the District
of Columbia, with total assets of over $1.9 billion.[98]Membership in ALAS is subject to careful ALAS
underwriting, which includes "on-site underwriting reviews and significant
scrutiny" prior to acceptance.[99]ALAS also makes recommendations concerning
law firm structure and procedures.[100]

Insurance will not, by
itself, solve potential problems related to risk, but could spread risk and
supplement risk firewalls in the event of broad, systemic problems or network
failure.Insurance mechanisms may help
to implement the private market discipline that remains the core goal of U.S. financial
market regulatory frameworks.Regulators
thus could either encourage or require use of more industry insurance mechanisms
in financial markets.

Establishing
clearinghouses similar to those in the commodities arena might be another
avenue for monitoring and reducing risk.Clearinghouses have been suggested for CDS markets.[101]Industry-sponsored bailout pools may be
another industry-based mechanism for promoting the internalization of risk by
financial market participants.[102]Payments into the bailout fund could follow
an agreed-upon formula that might reflect an incremental fee attached to
certain types of financial market activities[103]
or could involve compensation holdbacks from employee bonuses.Regulators could monitor the composition of
any payouts from such private bailout funds.The goal of industry-sponsored bailouts would be to establish firewalls
around troubled or failed participating financial institutions and to execute
any necessary financial rescues using funds from financial market participants
rather than the general public.[104]Further, schemes organized by financial services
market participants that are subject to external regulatory oversight and
monitoring are likely to be far more effective than direct external regulation,
particularly with respect to management of complex risks.[105]

Risk management in
financial markets may be hindered by the current design of U.S. financial
market regulatory architecture.Indeed,
in 2008 the U.S. Treasury Department characterized the structure of U.S. financial
market regulation as "largely incompatible with [capital] market developments."[106]The financial services industry has seen a
significant convergence of the banking, securities, and insurance market
segments in recent years.[107]Unfortunately, regulatory architecture in the
United States
has not adapted to reflect changing industry configurations. Rather, U.S. regulatory architecture has
remained complex and fragmented[108] in the face of industry "consolidation,"
"conglomeration," and "convergence.[109]

Regulatory
fragmentation makes collaboration among various regulators difficult.[110]In the futures and securities arena, for example, prior to the credit
crisis, multiple regulatory authorities were responsible for regulating
different aspects of financial markets.These authorities included the Securities and Exchange Commission (SEC),
which had jurisdiction over securities, and the Commodity Futures Trading
Commission (CFTC), which had jurisdiction over futures.[111]The SEC and the CFTC split regulatory jurisdiction over derivatives.[112]Over-the-counter (OTC) derivatives were largely unregulated due to the
provisions of the Commodity Futures Modernization Act (CFMA).[113]Regulatory treatment of OTC derivatives is,
however, likely to change, and a number of post-credit crisis legislative and
policy proposals would impose greater regulation on OTC derivatives markets.[114]

Although
some market participants such as broker-dealers are more heavily regulated,[115]
other significant market actors, such as hedge funds, are typically structured
to take advantage of regulatory exemptions, causing them to be lightly regulated
under separate regimes from multiple federal regulators.[116]A number of self-regulatory organizations
(SROs), including the stock exchanges and the Financial Industry Regulatory
Authority, also have regulated in the securities and futures arenas, subject in
turn to additional regulatory oversight.[117]The large number of financial market regulators
and regulatory regimes in the United
States underscores that more regulation does
not necessarily lead to better regulation.Rather, this regulatory landscape has led to significant regulatory
fragmentation and has also contributed to regulatory gaps and failures that
diminish the effectiveness of regulatory frameworks. Furthermore, existing regulatory overlaps are
highly inefficient.

While the SEC/CFTC
regulatory split reflects the historical origins of futures in the agricultural
sector and stock markets in the financial sector,[118]
the split makes little sense in a world of hybrid financial instruments and
increasingly converged and networked securities and commodities markets.[119]Prior to the credit crisis, banking regulation was similarly fragmented,
distributed among multiple state regulators and five federal banking
regulators.[120]Insurance regulation remained the responsibility of the states, and
therefore similarly lacked cohesion.[121]"Regulators have attempted with varying
success to alleviate the problems of regulatory fragmentation through
interagency cooperation," but fragmentation still exists within individual
regulatory bodies.[122]

In contrast to the United States,
where regulatory frameworks reflect early twentieth century designs, other
countries have modernized their financial services regulatory frameworks.In the United Kingdom, for example, a
single primary regulator oversees financial markets, while a separate regulator
ensures financial stability.[123]When Australia recently modernized its
financial services regulatory structure, it adopted a Twin Peaks regulation-by-objective
model,[124]
and now has two primary financial market regulators, a separate system stability
regulator, and another regulator that focuses on nonfinancial market conduct
and consumer protection.[125]U.S. financial market oversight is
based on functional regulators whose operational spheres track industry
institutional structures of prior eras,[126] which leads to ineffective and
inefficient regulatory frameworks. Fixing
financial market regulatory shortcomings will require legislation that
transforms financial industry oversight in fundamental ways.

The potential
complexity of regulatory requirements has significant implications for
financial services firms, which may need to deal with multiple regulators and
requirements.Further, existing U.S. financial
market regulatory structures are not well suited to the pervasive trading
activities that currently characterize financial markets and do not effectively
regulate such activities.In this
trading-centered universe, the activities of individual market players are not
easily located within the existing scope of regulatory enforcement.AIG, for example, "a heavily regulated
insurance company at both the federal and state level, has subsidiaries that
have been major issuers of [CDS]" contracts.[127]The CDS is a "major OTC
derivatives insurance product that is a significant force in financial markets."[128]"Although AIG is an insurance company
whose main insurance subsidiaries are regulated by the states in which they do
business,"[129]
prior to the credit crisis, AIG's holding company and subsidiaries were also subject
to prudential federal banking oversight by the Office of Thrift Supervision
(OTS) because AIG has a federal savings bank subsidiary.[130]The extensive and layered regulation of AIG "failed
to avert its near collapse and need for a government bailout and takeover."[131]The regulation of AIG illustrates core
features of the U.S.
financial regulation frameworks that typically determine regulatory oversight
by a combination of functional and institutional factors.Under this typical regulatory framework,
regulatory classifications are sometimes given more importance than the nature
of the activities occurring within a firm.

The flurry of reform
proposals following the credit crisis reflects widespread recognition that the
existing financial market regulatory architecture is not a good fit for current
financial market system dynamics. However, the enactment of yet more regulation
is unlikely to do much to prevent the next crisis.Financial market regulatory frameworks should
continually be evaluated to ensure that they are both effective and efficient.Moreover, the inefficient and patchwork U.S. system is
costly for regulated entities.The fact
that the current crisis unfolded within entities that are subject to significant
regulation does not bode well for the ability of existing frameworks and
regulators to identify and create firewalls around sectors or entities that
threaten market integrity.The
fragmented nature of financial markets regulation makes an accurate assessment
of systemic risk difficult, because each separate regulator lacks a comprehensive
vision of the system as a whole.Further,
regulatory coordination with respect to systemic risk management may be
hindered by existing regulatory turf battles.[132]

5. In
January 2010, for example, President Obama proposed yet another Wall Street
reform plan that would limit the size and activities of the kinds of
institutions that in the past were considered "too big to fail."Press Release, White House, Office of Press
Sec'y, President Obama Calls for New Restrictions on Size and Scope of Fin.
Insts. to Rein in Excesses and Protect Taxpayers (Jan. 21, 2010),http://www.whitehouse.gov/the-press-office/president-obama-calls-new-restrictions-size-and-scope-financial-institutions-rein-e
(link).

8. See Ian Greener, Nick Leeson and the Collapse of Barings Bank: Socio-Technical Networks
and the ‘Rogue Trader', 13 Org.
421 (2006) (discussing Nick Leeson and how his unauthorized and risky trades
led to the collapse of his employer Barings Brothers in 1995); see also Kimberly D. Krawiec, The Return of the Rogue, 51 Ariz. L. Rev. 127 (2009) (discussing
instances of rogue traders and the losses such traders generated for their
firms) (link).

13. Garry
J. Schinasi, R. Sean Craig, Burkhard Drees & Charles Kramer, Modern Banking and OTC Derivatives Markets:
The Transformation of Global Finance and its Implications for Systemic Risk 3,
6 (Int'l Monetary FundOccasional
Paper 203, 2000) (noting that the
dynamics of modern finance aremuch more complex than those of
traditional banking deposit markets and that "[b]ecause each derivatives portfolio
is composed of positions in a wide variety of markets, the network of credit
exposures is inherently complex and difficult to manage").

14. Bank for Int'l Settlements (BIS), BIS Quarterly
Review: International Banking and Financial Market Developments 22 (Dec.
2009), http://www.bis.org/publ/qtrpdf/r_qt0912.htm (link).Notional amounts reflect the principal value
of the underlying assets on which the derivative is based, represent a measure of
market size, and serve as a reference point for determining contractual
payments.BIS, OTC Derivatives Market Activity in the First Half of 2008 at4 (Nov. 2008),
http://www.bis.org/publ/otc_hy0811.pdf[hereinafter BIS, OTC Derivatives
Market] (link).Notional amounts, however, are not typically
exchanged, U.S.Gov't Accountability Office, Financial
Derivatives—Actions Needed to Protect the Financial System 28 n.7 (1994)
(link), and do not
represent a true measure of risk.Instead, the gross market value of derivatives, which measures the cost
of replacing all existing contracts, is a better measure of market risk.BIS,
OTC Derivatives Market at 4–5.

20. See Jonathan Macey, Obama and the ‘Fat Cat Bankers', WSJ.com,
Jan. 12, 2010,
http://online.wsj.com/article/SB10001424052748704081704574652622742100550.html ("But
we must get out of the business of guaranteeing against failure. The bankers and the shareholders who enjoy the
rewards of risk-taking should be made to act like real capitalists: They should
be required to assume the risks that go along with the banks' business
activities.") (link).

23. Alex
J. Pollock, Is a ‘Systemic Risk Regulator'
Possible?,American.com, May
12, 2009,
http://www.american.com/archive/2009/may-2009/is-a-2018systemic-risk-regulator2019-possible
("[T]he failure of individual firms is not only necessary, but in the systemic
sense, desirable.") (link).

24. Patricia
A. McCoy, Andrey D. Pavlov & Susan M. Wachter, Systemic Risk Through Securitization: The Result of Deregulation and
Regulatory Failure, 41 Conn. L. Rev.
1327 (2009) (detailing the chronology of deregulation and subsequent
failure to enforce existing regulations that led to the credit crisis) (link); id. at 1366("In sum, deregulation and federal regulators' subsequent
failure to exercise their traditional oversight powers laid the foundation for
the underpricing of risk and the erosion in lending standards.").

25. Edward
L. Glaeser, A Failure of Regulation, Not
Capitalism, N.Y. Times Economix Blog,
June 9, 2009, 06:00 EST,
http://economix.blogs.nytimes.com/2009/06/09/a-failure-of-regulation-not-capitalism/
("But it is foolish to react to a governmental failure and think that the right
response is to vastly increase the scope of public activity.") (link).

26. Scott Patterson, The Quants: How a New Breed of
Math Whizzes Conquered Wall Street
and Nearly Destroyed It 158–60 (2010); Robert
J. Shiller, The Subprime Solution: How Today's Global Financial Crisis Happened,
and What to Do About It 101 (2008).

32. Garcia & Goossens, supra note 27,
at 183 (discussing the systemic risk implications of investors' substituting a
single name bond for a securitization note, which substitutes idiosyncratic
with systemic risk).

33. See Donald MacKenzie, End-of-the-World Trade, 30 London Rev. Books 24, 24–26 (2008), available at http://www.lrb.co.uk/v30/n09/donald-mackenzie/end-of-the-world-trade
(describing the loss of reliable facts to form the basis for trades and its
exacerbation of the credit crisis) (link).

35. See, e.g., Bill Maurer, Repressed Futures: Financial Derivatives'
Theological Unconscious, 31 Econ.
& Soc'y 15, 21 (2002) (noting that Black Scholes "fostered a
tremendous expansion in the options market, because it seemed to allow a sure
method for options pricing and an investment strategy based on using options to
hedge against risk"); Stephen M. Schaefer, Robert
Merton, Myron Scholes and the Development of Derivative Pricing, 100 Scand. J. Econ. 425, 425–26, 441–443
(1998) (noting the impact of the Black-Scholes model on the development of the
financial services industry).

41. Id. at 116–17 (noting that 1997 Nobel
Laureate in Economics winners Robert C. Merton and Myron Scholes were among the
principals at LTCM); PWG, supra note 39,
at 10 ("LTCM's principals included individuals with substantial reputations in
the financial markets and especially in the economic theory of financial
markets.").

42. See generally Edward Chancellor, Devil Take the Hindmost: A History of Financial
Speculation 339 (2000) (noting that convergence trading is "a
backward-looking type of speculation based on an extrapolation of historic
price patterns"); PWG, supra note 39,
at 10 & nn.13, 14 (noting that "LTCM sought to profit from a variety of
trading strategies, including convergence trades and dynamic hedging," and
describing convergence trading (relative value arbitrage) as "the practice of
taking offsetting positions in two related securities in the hopes that the
price gap between the two securities will move in a favorable direction" and
dynamic hedging as "the practice of managing nonlinear price risk exposure (i.e., from options) through active
rebalancing of underlying positions, rather than by arranging offsetting hedges
directly").

47. Id.
at 43 ("In 1994, Long-Term noticed that this spread was unusually wide.The February 1993 issue was trading at a
yield of 7.36 percent.The bond issued
six months later, in August, was yielding only 7.24 percent, or 12 basis points, less.").

48. Id. at 44; Richard A. Brealey, Stewart C. Myers & Franklin Allen,
Principles of Corporate Finance 369 (9th ed. 2008) (noting that a person
selling short holds the view that a stock price will decline).Short selling is typically accomplished as
follows: the person selling short borrows shares from an investor, sells the
shares, waits for the price to decline so that the stock can be repurchased at
a price lower than the original sale price, and returns the borrowed shares to
the initial lending investor.

51. Id.
(noting that LTCM also substantially reduced or refused to take haircuts or
post collateral on the bonds it borrowed).

52. See id. at 207–208 (noting that new
equity of $3.6 billion was contributed in exchange for 90 percent equity in
LTCM); PWG, supra note 39,
at 12 ("The LTCM Fund's size and leverage, as well as the trading strategies
that it utilized, made it vulnerable to the extraordinary financial market
conditions that emerged following Russia's devaluation of the ruble and
declaration of a debt moratorium on August 17 of last year. Russia's actions sparked a ‘flight
to quality' in which investors avoided risk and sought out liquidity."); Joseph
G. Haubrich, Some Lessons on the Rescue
of Long-Term Capital Management (Fed. Reserve Bank of Cleveland Discussion
Paper No. 19, 2007) (describing the full history and details of LTCM's rescue
by the Federal Reserve Bank) (link).

54. See, e.g., CEO Pay and the Mortgage Crisis: Hearing Before the H. Comm. on
Oversight and Government Reform, 110th Cong. 166 (2008) (testimony of
Charles Prince, former Chairman and CEO, Citigroup) ("Last fall, it became
apparent that the risk models which Citigroup, the various rating agencies, and
the rest of the financial community used to assess certain mortgage-backed
securities were wrong."); see generally James
Surowiecki, That Uncertain Feeling, NewYorker.com, Sept. 1, 2008,
http://www.newyorker.com/talk/financial/2008/09/01/080901ta_talk_surowiecki
(discussing market volatility in 2008, noting that "[p]recipitous falls in the
market have frequently been followed immediately by sharp rallies, and vice
versa.") (link).

63. Int'l Monetary Fund, World Economic Outlook and
International Capital Markets: Interim Assessment 35–36 (1998),
http://www.imf.org/external/pubs/ft/weo/weo1298/pdf/file3.pdf (noting that "the
devaluation and unilateral debt restructuring by Russia sparked a period of
turmoil in mature markets that is virtually without precedent in the absence of
a major inflationary or economic shock") (link);
Lowenstein, supra note 40,
at 135–149.

73. Secs. Exch. Comm'n, Office of Inspector Gen.,
SEC's Oversight of Bear Stearns and Related Entities: The Consolidated
Supervised Entity Program, Report No. 446-A, at 7 (Sept. 25, 2008) [hereinafter,
SEC Inspector General Report A] (link); A Personal View of the Crisis: Confessions
of a Risk Manager, Economist, Aug.
9, 2008, at 72 [hereinafter Confessions]
("Liquidity risk was in effect not priced well enough; the market always
allowed for it, but at only very small margins prior to the credit
crisis. . . . The gap in our risk management only opened up
gradually over the years with the growth of traded credit products such as CDO
tranches and other asset-backed securities. These sat uncomfortably between
market and credit risk.") (link).

75. CRMPG
III, supra note 4,
at 4 (noting that the patterns, speed, and reach of the credit crisis contagion
are "different in degree, if not kind, from . . . earlier
periods of financial instability").

84. See, e.g., Glaeser, supra note 25
("The current crisis has revealed as utter fiction the idea that banks can fail
without imposing costs on the rest of us. Since bank failures impose costs on everyone
else, the banking system needs more regulations to internalize those
externalities.").

95. See generally Steven L. Schwarcz, Systemic Risk, 97 Geo. L.J. 193, 196 (2008) (describing "a
great deal of confusion about what types of risk are truly ‘systemic'—the term
meaning ‘[o]f or pertaining to a system'—and what types of systemic risk should
be regulated.") (link).

102. See Dale B. Thompson, Why We Need a
Superfund for Hedge Funds 2 (March 8, 2009) (unpublished manuscript, available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1358349)
(arguing for a "Superfund", comprised of taxes on hedge funds, akin to the "Superfund"
used in environmental regulation) (link).

103. See, e.g., id. ("The magnitude of this ["Superfund"] tax would be determined
by the amount of liquidity risk posed by the portfolio choices of the hedge
fund.") (footnotes omitted).

104. See, e.g., id. (hypothesizing that the "Superfund" could be used to purchase
distressed financial assets).

105. Rafael
La Porta, Florencio Lopez-De-Silanes & Andrei Shleifer, What Works in Securities Laws?, 61 J. Fin.
1, 27–28 (2006) (finding in empirical study that securities laws are most
important in facilitating private contracting, and that common law securities
laws more effectively spur such contracting, standardized disclosure, and
private dispute resolution than public securities laws and their regulatory
enforcers do).

108. See Comm.
on Capital Mkts. Regulation, The Global Financial Crisis: A Plan for Regulatory
Reform v (2009) ("The U.S.
financial regulatory framework can be summed up in four words: highly
fragmented and ineffective.") (link);
see alsoGAO, Financial Regulation: Industry Trends Continue to Challenge
the Federal Regulatory Structure 18 (2007) [hereinafter GAO, Financial Regulation] (pointing out
that industry participants offering similar services and engaging in equally
risky activities may be subject to different rules and oversight by different
regulatory bodies) (link).

110. Id. at 17–18; Group of Thirty (G30), The Structure of
Financial Supervision: Approaches and Challenges in a Global Marketplace 210
(2008) (noting that "[t]he complex array of supervisory agencies [in the United States]
requires a high degree of coordination").

116. See Arewa, supra note 4,
at 30–32 (describing how hedge funds may be subject to SEC, CFTC and Federal
Energy Regulatory Commission oversight, and may be required to become members
of the National Futures Association, a futures industry self-regulatory
organization (SRO)).

117. See GAO, Securities
and Exchange Commission: Opportunities Exist to Improve Oversight of
Self-Regulatory Organizations 1 (2007) (link); G30, supra note 110,
at 213 (discussing the role of SROs, in the U.S. securities and futures
industry regulations, of establishing and enforcing rules governing member
conduct and trading, monitoring trading activity to prevent market manipulation,
and examining members for financial strength).

118. See Treasury
Blueprint, supra note 2,
at 45 (explaining that the Department of Agriculture initially had federal
jurisdiction over futures markets and that congressional CFTC oversight remains
vested in the Senate and House Agricultural Committees); William G. Ferris, The Grain Traders: The
History of the Chicago Board of Trade (1988) (discussing the origins of
the Chicago Board of Trade).

119. See Treasury
Blueprint, supra note 2,
at 11 ("The realities of the current marketplace have significantly diminished,
if not entirely eliminated, the original reason for the regulatory bifurcation
between the futures and securities markets."); see also Letter from Marc E. Lackritz, President & CEO, Sec.
Indus. & Fin. Mkts. Ass'n, to Jeffrey Stoltzfoos, Senior Advisor, Office of
the Assistant Sec'y for Fin. Insts., U.S. Dep't of Treasury, & Mario
Ugoletti, Dir., Office of Fin. Insts. Policy, U.S. Dep't of Treasury (Nov. 21,
2007), at 9–11, available at http://www.sifma.org/regulatory/comment_letters/58152600.pdf
(recommending consolidation of the SEC and CFTC) (link).

120. See Treasury
Blueprint, supra note 2,
at 32–42 (describing the history of banking regulation and the entities
historically responsible for banking industry oversight).

124. Twin
Peaks is a relatively new regulatory approach to financial market regulation
adopted by Australia and the
Netherlands
that is similar to the integrated approach exemplified by the U.K. Financial
Services Authority.Arewa, supra note 4,
at 14.The integrated approach involves
consolidation of financial market regulation under a single financial market
regulator.Id.To avoid potential conflicts in the
integrated approach between prudential or safety and soundness regulation and
conduct of business/consumer protection, the Twin Peaks approach separates
prudential safety and soundness regulation from conduct of business
regulation/consumer protection and has separate regulators for each regulatory
objective.Id.
at 14, 37–38.

126. Treasury Blueprint, supra note 2, at 139 (characterizing the U.S. regulatory system as an institutionally
based functional system); GAO, supra
note 111,
at 9 ("[F]inancial products or activities generally are regulated according to
their function, no matter who offers the product or participates in the
activity.Broker-dealer activities, for instance,
are generally subject to SEC's jurisdiction, whether the broker-dealer is a
subsidiary of a bank holding company subject to Federal Reserve supervision or
a subsidiary of an investment bank.").

130. AIG
Report,supra note 127,
at 13 (noting in 2007 that AIG is subject to OTS regulation, examination,
supervision and reporting requirements, and that since its subsidiaries are
subject to OTS enforcement authority, OTS can restrict or prohibit activities
that are "determined to be a serious risk to the financial safety, soundness or
stability of AIG's subsidiary savings association"); Posting of Justin Fox to
Curious Capitalist Blog, The Government's
AIG Dilemma,
http://curiouscapitalist.blogs.time.com/2008/11/10/the-governments-aig-dilemma
(Nov. 10, 2008, 13:19 EST) (noting that OTS examiners regularly reviewed the
accounts of AIG Financial Products and that AIG was subject to closer federal
scrutiny than Bear Stearns or Lehman Brothers) (link).